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5 Years on, 5 Lessons From Bear Stearns' Collapse

There's plenty that we can learn from the failure of Bear Stearns. Here are five lessons for investors.

On March 16, 2008, Bear Stearns agreed to sell itself to JPMorgan Chase (NYSE:JPM) for $2 per share. The deal capped a breathtakingly rapid fall from grace of one of the major Wall Street players as the market lost faith in the firm and its balance sheet and financing partners stepped away.

There are any number of lessons that we can take away from the demise of Bear, but the following are five that stand out in particular to me.

1. "Too big to fail" means little to shareholders.Bear Stearns was considered "too big to fail." As the first of the major Wall Street firms that was staring down the barrel of bankruptcy, the government played a major role in the shotgun marriage between Bear and JPMorgan. For bondholders, this meant everything -- they got 100 cents on the dollar. For equity holders, it was a completely different story.

Source: S&P Capital IQ.

Bear's stock traded above $170 in early 2007 and was still fetching $30 the Friday before the $2-per-share deal with JPMorgan. Equity holders likely had plenty of colorful descriptors for how they felt after the deal, but "bailed out" was probably not among them.

Looking out over the banking landscape today, we see plenty of "too big to fail" banks. Bear's parent, JPMorgan is one of them. Bank of America, Citigroup, and Wells Fargo are all undoubtedly too big to fail as well. Investment banking giants Goldman Sachs and Morgan Stanley probably belong in that group as well.

But make no doubt about it, if any of these banks do mess around and get themselves into trouble, it's not the shareholders that will get rescued.

2. Management matters.If there's one single thing for investors to take away from the financial crisis, it's the importance of management. Wells Fargo CEO John Stumpf -- and Dick Kovacevich before him -- isn't on the ground making loans, but senior leadership is setting the tone for the company and deciding when to push forward and when to go on the defensive. Thanks to strong, conservative management, Wells performed well through the crisis. Citi -- whose then-CEO Chuck Prince famously quipped, "As long as the music is playing, you've got to get up and dance... We're still dancing." -- didn't.

It's easy to paint a caricature of the cigar-chomping, bridge-playing Jimmy Cayne at Bear Stearns. Cayne famously ticked off everyone else on Wall Street when he refused to join in on the consortium bailout of Long-Term Capital Management in 1998. Instead of being at the helm of the troubled ship as Bear started to falter, Cayne was often traveling to bridge tournaments instead. And aside from his ubiquitous cigars, it's also been reported that he was a more-than-occasional pot smoker. Anecdotes don't paint the full picture, but they're certainly telling.

In the wake of Knight Capital's epic trading meltdown last summer, one Wall Street executive called Knight CEO Tom Joyce "a stand up guy who is admired, respected and trusted by his peers" and said that "the financial services industry went out of its way to save Knight Capital."

I've yet to find any postmortem commentary about Cayne with that kind of glowing tone.

3. Leverage killsBear Stearns was levered 34-to-1 in the quarter before it went under. That is, its total assets were 34 times its equity cushion. And looking back historically, this wasn't a new phenomena for Bear.

What this means practically is that it would only take a very small loss -- around 3% of assets -- to wipe out the bank's equity completely. Value investing forefathers Ben Graham and David Dodd coined the term "margin of safety," which essentially means building in some buffer in case you're wrong.

It's really very simple: With 34-to-1 leverage, there is no margin of safety.

4. Here today, gone tomorrow financingWhile the leverage noted above was dangerous enough, compounding the risk was the fact that a healthy chunk of Bear's financing -- typically between a quarter and a third of its liabilities -- came from repurchase loans.

Repo loans are short-term financing arrangements -- often as short as overnight -- in which the lender provides capital in exchange for an interest payment and collateral to hold for the period of the loan. In "normal" times, this can seem like a perfectly fine source of financing -- it's flexible and usually very cheap. When the skies start to darken, though, repo lenders may get squirmy and reduce the amount of lending they're willing to do, require higher-quality collateral, or simply pull the funding altogether.

When rumors started swirling about the condition of Bear's balance sheet, it was the evaporation of this fair-weather capital that helped push it over the edge.

5. It's all very easy tosayIn Bear Stearns' final annual report, the company spends pages upon pages expounding on its systems for managing risk and ensuring ample liquidity. The introduction to its review of its liquidity framework reads:

The Company maintains a rigorous framework and commits substantial time and effort to the management of liquidity risk. The Global Finance Committee, in consultation with the Chief Financial Officer, has established a funding framework for the Company. This framework ensures flexibility to address liquidity events, maintains stability and continuity of funding in all market environments, and includes targets and guidelines around key liquidity measures.

That certainly sounds good. As do the 8,500-plus words that follow in its discussion of funding and liquidity.

But as became painfully obvious in March of 2008, the bank's measures did not allow for adequate funding through "all market environments." Putting words on a page is an easy thing to do. But just because a company says it can do something -- like maintain liquidity through all market environments -- doesn't mean it will be able to.

The bottom line? Investors need to hang on to common sense. A management team can say that it has an extensive funding plan and a solid balance sheet, but when you see it levering to nosebleed levels using short-term financing, caution needs to be the watchword.

Matt Koppenheffer owns shares of Bank of America and Morgan Stanley. The Motley Fool recommends Goldman Sachs and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.